by Suhani Adilabadkar
As the eternal conflict between value and price continues, investors are busy looking into ever more complex tools for evaluating stocks, while keeping up with all the data indicators and disclosures coming their way. What does a genuine investor do?
Simple: Go Back To Basics. Stock evaluation is common sense entwined with interpretation of financial information the right way. The first thing that any investor irrespective of his experience with the world of stock market wants to know and should know is - The ROE. is like asking the run rate of an on going cricket match to check whether the things are moving in the right direction.
ROE - Defining Profitability
Return on Equity, is the first step to analyze efficiency of any business. In simple words, it measures the company’s profitability by expressing Net Profit as a percentage of shareholder’s equity. It is an instrument to measure the efficiency
with which shareholder’s capital is utilized for generating consistent profit.
The higher the ratio, the better and is a useful tool for comparing within the same industry. Different industries have a different baseline for the ratio, depending on the level of investment and assets required. For instance, the IT industry will have a higher
ROE than banking, aluminium or copper or defence.
Major ROE multipliers - Sensex & Nifty
It is the old standby Hindustan Unilever that tops the chart for the highest ROE of 69.20 among the BSE Sensex companies followed by Coal India, Hero Motocorp & Tata Consultancy. All of these firms score above 30 on an annual basis. For Nifty Fifty, the top end also includes Zee Entertainment, Eicher Motors and Hindustan Petroleum maintaining the above 30
levels.
Though 30 is a strong score in the current scenario, Indian companies have witnessed high ROE erosion especially after 2007. ROE for BSE 200 ROE fell from a high of 22.50 in 2007 to 11.50 in 2016. As a result of the 2008 financial crises, the profitability of Indian companies was battered, with lower growth and margins for every industry. So when the analysts talk about corporate earnings turn around, they mean ROE growth which signifies broad based improvement of Indian corporate financial health.
Industry Specific or Company Value Picker
The FMCG Industry gives one of the best ROEs followed by auto, auto parts, cement, consumer durables, Oil&Gas. The classic case of ROE turnaround is the IT industry over the previous few quarters. With markets favoring banks and other financial services over the past 3-4 years, IT industry was considered a laggard by markets veterans and even mutual funds as seen from their low holding in the IT industry.
All major IT companies saw a bounce back later, gradually finding favour with both FIIs and domestic investors as they provides high and stable ROE.
The outliers in industries
Return on equity signifies sustainable growth rate for the company in the long run. Over the previous few years, FIIs and DIIs had become more stock specific to achieve their target alpha. The industry as a whole takes time to recover depending on macro factors and other systematic risks. Companies on the other hand within the industry, function as independent units and are able to manage variables with
respect to changing economic conditions.
As a result we have Hindustan Unilever with its ROE of 69 and Dabur, Marico at 26 and 36 respectively. On the same lines, Tata
Consultancy and Infosys reported 30 and 20 respectively in ROE. Eicher Motors, Page Industries, Avanti Feeds, Castrol India are some of the outliers in terms of high ROE in their respective industries.
ROE - harmonizing with the overall financial orrchestra
Return on equity, being a basic tool for measuring efficiency cannot be used in isolation. It should be considered as a stepping stone to stock selection and evaluation. It’s major drawback lies in its denominator, shareholder’s equity which can be manipulated by high debt component in the capital structure to enhance ROE.
Thus ROE should be viewed in conjunction with other financial parameters such as ROCE, ROA and Cash flow. Though ROE cannot be used in isolation, it should not be forgotten in the maze of the other financials.
Suhani Adilabadkar is a Research Analyst registered with SEBI ((INH200003240)) She has done PGDBA (Finance), MS (Finance) and a Fellowship from Insurance Institute of India. She maintains a blog at oasisfundamentals.blogspot.in.
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